What Does it Mean to Properly Consider Risk?

I once had a student who came into my office and eagerly declared, “I want to invest in stocks!”

I asked him why.

He said, “my roommates are all making so much money, I want in! They bought AMC at $10 and it’s now $50!”

One important marker that separates a beginning investor from a more mature investor is their understanding of risk. Beginner investors who have been regaled by tales of easy money rarely consider risk properly.

But what does it mean to properly consider risk?

Calculating risk

The traditional way to consider risk is to simply calculate it. When calculating risk, most investors use a statistical measure of dispersion around a historical average such as standard deviation, volatility, beta or downside deviation.

For example, if I had a stock that has historically returned 10% per year with a 20% standard deviation, then 95% of the time that stock is predicted to create a return that is between -30% and +50% (i.e., 2 standard deviations +/- the average return). The higher the standard deviation, the more potential for the investment to deviate far from its average return.

Once the preferred measure of risk is calculated, then an investor is considered “grown up” if they then seek to maximize their risk-adjusted returns. A common way to measure risk-adjusted returns is to use the Sharpe ratio, which essentially takes the expected return of an investment and divides it by a measure of risk. The higher the Sharpe ratio, the more return you are getting given the same amount of risk.

There is more to risk than numbers

So, is that it? Is considering risk properly simply a matter of calculating risk-adjusted returns?

I have never been satisfied to stop at risk-adjusted returns — there is something more that needs to be considered. What if risk is not just a matter of the head, but also of the heart? Put another way, what if risk actually has the potential to form us as people?

If this is true, to properly consider risk we would need to both calculate it (i.e., “head”) and consider how it may form us (i.e., “heart”).

When I was 15, I bought my first stock. It was 1995 and just about every stock was going up. I bought the stock and instantly made money, and it felt really, really good. This really-good feeling was the brain chemical dopamine, which helps give us a sense of pleasure and motivation. The more extreme the markets got, the more chances there were for big hits of dopamine.

I began to like risk since it meant the chance for big wins. The more I engaged, the more my personality began to gradually shift. Before investing, I was a normal “risk-averse” individual. But after all of the fun of investing, I was forming into a “risk-seeking” individual. My brain loved the dopamine and I knew that seeking out risk was the way to get more.

Numerous studies have shown how the brain changes when receiving regular doses of dopamine. In one study, “Dopamine Agonist Increases Risk Taking but Blunts Reward-Related Brain Activity,” scientists discovered that the brain was clearly altered when participants were given regular doses of dopamine.

When risk becomes gambling

The more risk, the more opportunities there are for intense doses of dopamine. This has the potential to form us into risk-seeking individuals, and another name for “risk-seeking individual” is gambler. Gambling addiction has been described by some psychologists as the hardest addiction to overcome. From the beginning of civilization, gambling has left devastated families in its wake.

There is a scene in the 2001 movie Rat Race that epitomizes how risk has the potential to rewire you from a fruitful, risk-averse individual into someone more destructive and risk-seeking. The movie is centered around a group of risk-hungry gamblers taking a handful of random strangers, placing a million dollars in a duffle bag a few hundred miles away and then betting on which stranger will reach the money first. As the strangers engage in a “rat race,” the most interesting scene to me is when the rich gamblers begin to gamble on all sorts of other random things, from climbing curtains to how hotel staff would respond to certain questions. For the gamblers, the thrill of the race was not enough dopamine for them — they needed more and more and more. Having a risk-seeking brain means you are constantly seeking out dopamine, creating a spiral that leads towards more and more addictive behavior.

This Rat Race scene is being replayed in today’s culture. Easy gains during the last 10+ years have led to a generation of risk-seeking investors who usually begin with stocks, then move to more risky crypto investments, and then end up in the completely untamed NFT/metaverse markets where a picture of a snail pooping a rainbow is valued at a million dollars.

When risk becomes paralyzing

This is not the only way that the experience of risk has the potential to form you as an individual. It can have the opposite effect as well.

When my wife bought a townhouse in 2007 as a single woman, she did it mainly because everyone said “you need to do it! Real estate is a sure thing!” Within months, her property was severely underwater and worth less than she owed on it. The experience changed her into someone now very fearful of any type of risk.

This rewiring of the brain to over-assess risk goes much deeper than just financial education. For many people, the experience of the real estate and stock market drops in 2008 were enough to keep them out of these markets for years afterward, when it was actually the best possible time to engage them.

Risk forms us

So, in order to properly consider risk, we must:

Determine an appropriate way to calculate the risk of any investment we are considering.
Consider how we will experience that risk and whether the experience of the risk will change us as people.

For any investment, if the risk cannot be calculated — I’m looking at you, crypto and NFTs — it is likely a very bad idea. I know that if I were to invest in things where I would not be able to calculate the risk, all of my deep-formed convictions about investing would be broken. This would change me into a person I do not want to be.

Whenever my students ask me about investing in Bitcoin, I like to ask them, “will it change you?” Assuming the best-case scenario, and you make lots of money without understanding the risk, will you change as a person?

If you ask anyone whether they will become a worse person for winning the lottery, every single person will deny that they will change. But studies have shown that — for most people — winning the lottery fundamentally changes them into a less satisfied and more addictive person.

I have two tips to avoid having risk form us the wrong way:

Fear risk – demand to know the risk of something before you invest. If you don’t know why something goes up or down, then you are likely engaged in risk-seeking, gambling behavior.
Once you buy something, consider owning it for 10-20 years and only check its price once a month or perhaps twice a year. This will lead to less intense signals to your brain and reinforce a long-term perspective. In other words, it’s boring, and boring is good for the heart and mind.

There are thousands and thousands of “boring” investors who didn’t get those hits of dopamine — they simply bought and held a diversified portfolio of stocks and became financially healthy. Unfortunately, there are also thousands and thousands of people who sought out quick riches and are bankrupt, both financially and emotionally. In fact, this road to destruction is so well-worn that the Bible has clear warnings about it:

“Those who want to get rich fall into temptation and a trap and into many foolish and harmful desires that plunge people into ruin and destruction.” — 1 Tim. 6:9

Avoid financial short-cuts — chasing after get-rich-quick schemes is often just veiled greed.

“Watch out! Be on your guard against all kinds of greed; life does not consist in an abundance of possessions.” — Luke 12:15

In the end, I recommend that you be like my Nana, who bought a boring portfolio of high-quality stocks and then forgot about them until her retirement. This boring way gave her what she needed when she needed it, without putting her heart at risk.

This article was originally published by Faith Driven Investor. Photo by Loic Leray on Unsplash, used under license.

Please join us on March 15 at 12 p.m. for a virtual Information Session about Crowell’s Graduate Certificate in Personal Financial Planning (MCFP) led by Dr. Enete.